Could the Midwestern Drought Cause a Global Crisis?

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The news from the U.S. Department of Agriculture wasn’t quite as it bad as it could have been. But the weekly report indicating that less than a quarter of this year’s corn crop can be rated as being in “good” or “fair” condition, compared to 62 percent of it at this time last year, was enough to send prices of both corn and soybeans back toward record highs.

That’s great news for investors – agricultural commodities have handily beaten most other asset classes so far this year as a place where investors have been able not only to generate positive returns but capture gains of 20 percent or more, depending on their ability to buy into the right contract at the right time, and roll that contract over when it approaches expiry.

The cause underpinning the gains is, of course, the drought that has swept through most of the mainland United States; even last week’s storms didn’t leave enough moisture behind them to help get the corn and soybeans through the critical next week or two of their growing season. Some regions didn’t see much rain at all, including parts of major corn-growing states like Iowa. There’s a bit of wiggle room left for soybeans, but for much of the corn crop, even if the rest of the summer is a rainy washout for vacationers, it will simply be too late for farmers and their crops to get any benefit.

It’s the eighth week running that the weekly USDA crop condition report has cautioned that the state of this year’s harvest is deteriorating. The last time the agency was this bearish on crop conditions was all the way back in 1988, and commodity analysts are drawing ominous comparisons between the summer of 2012 and epic droughts of the kind experienced all the way back in the 1950s.

Obviously, this is devastating news for many farmers. But those of us living in urban areas and whose wellbeing isn’t tied to the farm economy or to crops shouldn’t think that the impact on us will be confined to paying a little bit more for products containing corn (an astonishing array of things fall into that category) or meat (because a hefty portion of the corn crop is devoted to feeding animals). Firstly, there’s the impact on government finances to consider, on both a local and state level: As meteorologist Jeff Masters of the Weather Underground noted recently, two of the three most costly disasters since 1980 have been droughts, not the more dramatic events such as hurricanes or floods.

And since those droughts hit in the 1980s, the nature of commodity markets has changed. Once the domain of big agricultural firms like Archer Daniels Midland (ADM), farmers and others who needed to hedge the risks associated with volatile crop prices ahead of the growing season (along with a handful of commodity trade advisors who ran funds that invested in agriculture futures along with scores of other listed derivatives products) today’s commodity markets are full of speculators.

The impact of the latter on the price of crude oil has at times been dramatic and, some critics argue, has distorted the “real” price of the fuel. Without getting into yet another debate over the merits or woes associated with having speculators playing such an important role in shaping prices (they may make price moves more dramatic, but also can enhance liquidity), the fact remains that the “specs” can produce exaggerated gains.

Nor is the fallout only a matter of Americans paying $10 more on our average weekly grocery bill. (Not forgetting that for some, that, too, is an intolerable burden.) Because what is going on isn’t confined to North America; other grain-growing parts of the world, such as Russia and the Ukraine, are battling their own drought conditions, while European farmers are contending with the opposite problem, too much rain.

The result could be another food crisis that leaves the world’s poorest people unable to afford to purchase increasingly scarce and costly food, as the World Bank’s president, Jim Yong Kim, warned yesterday.

While the World Bank didn’t predict any major grain shortages, and noted that lower fertilizer and energy costs might help ease the burden of planting next year’s crop for farmers who have seen their incomes plunge as the crops have failed, even short-term problems can have a lasting impact on everything from health to education. (If a family can’t afford food, one of the first things they may stop spending on is a child’s school uniform, for instance.)

Ultimately, high food prices can prove to be politically destabilizing. Citizens whose governments can’t afford to subsidize food supplies may become restless – indeed, some analysts say that soaring food costs in 2007 and again in 2010 (along with corruption) were major triggers for the revolts in countries like Tunisia and Yemen that led to the Arab Spring in early 2011.

Monitoring the issues associated with corn and soybean prices is a vastly more complicated process than it was the last time that a drought of this size swept across the United States. Back then, more than a third of the corn harvest wasn’t being funneled into producing ethanol or other biofuels, leaving less available for food needs. Nor were as many investors putting as significant a chunk of their assets in what today we refer to as emerging markets, some of which will feel the impact of those higher commodity prices.

What, for instance, might happen in China if a generation that has become accustomed to eating more protein – meat several times a week instead of once or twice a month – has to go back to going meatless as the cost of animal feed skyrockets? It isn’t just the Midwestern farmers who will be anxiously watching the Weather Channel for a sign of an end to the drought.

Business journalist Suzanne McGee spent more than 13 years at The Wall Street Journal before turning to freelance writing. Author of the book Chasing Goldman Sachs, she has written for Barron’s, The Financial Times, and Institutional Investor.